Q: I see advertisements claiming 8% for bonds linked to prime mortgages. As interest rates are falling and you see rates fixed at 4.99% or variable at 5.1%, how can a bond linked to mortgages still return these rates? Won’t the income earned drop along with interest rates on variable interest mortgages?
A: Thanks for the question.
The standard variable home loan interest rate (from the four major banks) is currently around 6.25%. Further, many banks offer discounts to these rates through packages. Fixed rates residential home loan rates are even lower, with some around 5%.
So, an investment (for example, bond or mortgage trust) linked to prime mortgages paying 8% suggests that it must entail a higher level of risk.
There are a number of products in the market that effectively invest in prime mortgages. In many cases, they offer the potential of higher returns than available or implied by the standard variable mortgage interest rate, by:
- Investing in RMBS or Residential Mortgage Backed Securities. RMBS are issued over a pool of residential mortgages, and then divided into tranches. Each tranche has different return and risk characteristics. Typically, products offering these higher rates invest in the lower ranked or higher risk tranches – which are called upon first to cover the loss on a mortgage default; or
- Investing in non-residential mortgages (commercial, industrial, agricultural). Interest rates on commercial mortgages are higher than residential mortgage rates, and not unsurprisingly, so is the expected loss; or
- Investing in mortgages provided for the non standard parts of the market, such as bridging finance.
You shouldn’t be surprised by the forecast rate, although it will come down if interest rates (and the standard variable mortgage rate) fall further. The key issue is to understand the risk you are taking on – read the Product Disclosure Statement carefully, paying particular attention to the manager’s experience, internal credit processes, and risk management approach.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
Also in the Switzer Super Report:
- Charlie Aitken: Short Bernanke, long QBE [1]
- Maureen Jordan: My SMSF [2]
- Roger Montgomery: Brambles and the de-merger proposition [3]
- JP Goldman: Unhedged still a good choice [4]
- James Dunn: Is it time to get back into mining services? [5]
- Gavin Madson: Bernanke throws the cat amongst the pigeons [6]